Friday, November 28, 2014

The idea of regulatory
capture is a good one, and it’s the principal explanation that academic
economists offer for why regulators often — as a rule, in fact — don’t
act as firm and wholly independent judges of those they’re meant to
regulate. Whether they’re working to make manufacturers meet safety
standards, or banks avoid undue risks, regulators rarely act as stern
overseers, and often end up softening regulations to appease industry
desires. It’s not generally because they’re incompetent or corrupt
(although that’s sometimes true). Regulators are human beings, and hold
opinions which can be influenced by others. They happen to interact
mostly with those they regulate, and so end up getting influenced by the
regulated — not surprisingly, in ways that favor those parties.

For
example, regulators need information to do their jobs, and cooperation
with those they regulate is a good way — probably the best way, and
almost certainly the easiest — to get it. They try to get along with
those they regulate, and that implies some give and take, some
understanding and sympathy. Moreover, as regulators needn’t always
remain regulators, prospects for later employment also play a role. A
while back, my Bloomberg Views colleague Megan McArdle summarized
the natural logic of regulatory capture. It’s not really surprising at
all (although it may be surprising that we don’t do more to at least try
to avoid it).

Economists
are rightly proud of this analysis. It’s an example where thinking
carefully about ordinary human behavior, as people do their best to meet
their goals and get along with one another, goes a long way to
explaining an important phenomenon. However, I suspect that economists
may be less happy , possibly even a little alarmed, with the direction
in which one of their tribe — Luigi Zingales of the University of
Chicago — suggests the analysis ought to be extended.

What
about economists themselves? Are they the free authors of their ideas,
or are they, like regulators, significantly influenced in their thinking
by their interactions with business interests? Zingales suggests
the latter — and argues that we should, therefore, consider economists’
views with considerable skepticism. Overall, he concludes, the
profession and its publications most likely display a significant
pro-business and pro-markets bias, because many economists are captured.

Friday, October 10, 2014

I've just published a response to Paul Krugman's criticism of my recent Bloomberg article on limits to growth. It's over at Medium.com in the new collection Bull Market. I don't think Krugman's arguments carried a lot of weight, as you'll see. First paragraphs below....

**********

A few days ago I wrote a column in Bloomberg
exploring some ideas about possible physical (and
biological/ecological) limits to economic growth. I pointed out that
total global energy consumption continues to grow even as we learn to
use energy ever more efficiently. And I suggested — based on empirical
data from the recent past — that there’s little reason to believe, as
many economists quite confidently do, that our energy use will soon
“decouple” from economic expansion, enabling us to fly off into a future
of unlimited betterment through increasing economic output, even as we
come to use less and less energy. I also examined a few reasons why
continuing to use ever more energy is a certain path to ever worsening
ecological problems; it’s really not a wise option.

Economist and prolific New York Times columnist Paul Krugman was irritated, even exasperated, and fired off an “acerbic rebuttal”
(to use Noah Smith’s elegant description). He was aggravated that I, as
a physicist, was weighing in on topics he thinks should be left to
economists. He also suggested that I was just recycling an old argument
originally put forth by other physical scientists, which his fellow
economist William Nordhaus had completely demolished long ago. Now
Krugman had to rise up to do it again! How tiring!

But
Krugman’s actual argument was surprisingly weak, and I think grossly
misleading, so here’s an attempt to bring a little more clarity to the
discussion. I do think Krugman is a brilliant columnist, and I agree
with him on lots of things, maybe even most things. But he very much has
the wrong end of the stick on this one. Read more here.

Thursday, October 2, 2014

A few days ago, Paul Krugman made reference in one of his columns to some data
compiled by the US Energy Information Administration on trends in
energy use over the past few decades. The data touch on the question of
how much energy different nations use to generate $1 of GDP. Are we
getting more or less efficient in our use of energy? The numbers, as
Krugman argued, show we’re generally getting more efficient. Below I’ve
listed the numbers for US energy usage from the year’s 2001 through
2011, in sequential order, from left to right, separated by commas, the
units being BTUs per dollar of GDP:

So
you see, the amount of energy used to generate each bit of GDP is going
down. Same is generally true for other nations. Fair enough. I’m not
going to question that.

But
isn’t there something fishy about these numbers? The energy units are
BTUs, and the final entry says we used precisely 7,328.424 BTUs per
dollar of GDP in 2011. There are 7 specific digits reported in this
number, implying that we know our energy/GDP figure to an accuracy of 1
part in 10 million. It’s incredibly impressive. Think about that “.424"
at the end. It’s not “.425" or “.423" but exactly “.424".

Is
this at all meaningful? Of course not. It’s ridiculous. Unfortunately,
this kind of illusory accuracy infects economics and finance quite
widely. It may not be the most important issue in the world — even
writing about it makes me feel like a grumpy old man — but we’d all
think more clearly if we paid more attention to the numbers. So, what’s
wrong here? Read the rest in the new collection Bull Market at Medium.com

Friday, September 26, 2014

I do think the above image captures a truth. But I'm also not convinced that the forces driving politics from the Democratic side are all that much better. Anyway, I have a new thing up at Medium.com on political polarization and how it is worse now than ever, according to voting patterns in congress:

Political polarization and gridlock. It’s worse that ever, or at least
it seems that way. In fact, it is worse than it has been for 65 years.
That’s the conclusion of a recent study
by researchers who looked at the history of political polarization in
the US since 1949, as judged by congressional voting records. The study
found that cooperation between members of different parties is now
lacking more than ever before. Things were actually a lot better back in
the Nixon era, even during the most divisive days of the Vietnam War
and Watergate, when a President and Vice President were forced to
resign, and even in the aftermath of the assassinations of Martin Luther
King Jr. and Robert F. Kennedy.

Thursday, September 25, 2014

I just published a short essay reviewing the amazing book Who Owns the Future? by Jaron Lanier. It is published as part of a new business collection over at Medium.com, where I'll be writing with a number of other business and finance writers. First two paragraphs below. I really encourage everyone to buy and read this book. It's changed my entire perspective on the Internet and how it is affecting our economic lives:

Imagine that someone told you
that three of the biggest stories of the past few years — the financial
crisis, exploding economic inequality, and the National Security Agency
spy scandal — weren’t actually different stories at all. Different in
detail, yes, but essentially identical in their deeper cause. The cause,
they go on to say, wasn’t greed or fear or the age of terrorism or
anything else linked to human fallibility, but
technology — specifically, computation and its networked manifestation,
the Internet. Sound crazy?

Well,
it doesn’t if you hear out Jaron Lanier’s full argument. Lanier is a
Silicon Valley guru and one of the pioneers of virtual reality
technology; he’s helped build today’s technological reality and is
anything but a Luddite about technology and its potential for helping
people. But he does think the Internet has gone off the rails, that
we’re developing it in the wrong way, benefiting technology more than
people, and by design driving our economies into the swamp. I’ve come a
little late to Lanier’s book of last year — Who Owns the Future? — but I think it’s one of the most important things I’ve read in a decade.

Wednesday, September 10, 2014

The human race faces a huge quandary: The economic growth required to
support increasing living standards around the globe will, if we
continue with current practices, inevitably put the planet under extreme
and unsustainable stress. The case of road construction shows how the
process might be managed -- and how difficult it will be to do so.

Global
population and economic activity won’t keep growing as they have since
the Industrial Revolution. If they did, the ever-accelerating path
would lead to absurd infinities somewhere around 2050 or 2060. Growth
will hit natural limits well before then: We'll either destroy our
environment, or we'll learn to act very differently. As the late
computer visionary James Martin wrote in his book "The Meaning of the 21st Century,"
what's needed is a revolution in skills and means for managing the
consequences of our explosive technological growth so people can keep
improving their well-being while also preserving the planet.

Consider
the relatively simple challenge of building roads. Humans have already
laid some 30 million miles of roadways and are on course to build about
20 million miles more by 2050, a 60 percent increase in 40 years. Almost
all will be built in developing nations and regions of huge
biodiversity. New routes are today penetrating many of the world’s most
precious surviving wildernesses, including the Amazon, New Guinea,
Siberia and the Congo Basin.

This activity is a perfectly
understandable response to human needs. Industry is seeking valuable
resources such as timber or oil, farmers are clearing new land for
crops, governments are trying to make transportation and trade easier.
Unfortunately, there's far too little coordinated effort to reduce the
environmental impact. As a result, wildlife habitats will suffer huge
losses and ecosystems will be destroyed, ultimately undermining Earth's
capacity to support human life as well.

New research
by a group of environmental scientists suggests that better
coordination could go a long way toward avoiding this disaster. The key
is that vast tracts of settled land, where ecological damage is already
significant and probably irreversible, still aren't very productive.
Better access to fertilizers and modern farming technologies would
greatly boost the productivity of such areas, thereby reducing the need
for development in more sensitive areas.

The researchers have produced a global map
showing places on Earth where new roads or road upgrades could have big
human benefits, and others where little benefit would be expected
despite large environmental costs. If countries worked together, such
information could be used to guide road building over the coming
decades, helping to preserve the fragile biosphere without compromising
beneficial economic growth.

Such a global zoning plan would allow
building to take place in an intelligent way. Inevitably, of course, it
would also mean that some local interests would have to give way to
global demands. Governments, individuals and firms would sometimes be
constrained by the needs of the greater whole. That's what coordination
implies, and it's what we need if we're going to preserve our world and
still boost agriculture to meet the global demand for food, which will
likely double by 2050.

Will it happen? The prognosis is not good.
Politicians are too focused on the next election -- and often too
corrupt or beholden to local economic interests -- to think globally and
for the long term. For many conservatives and libertarians, any step
toward even minimal global governance seems to produce near hysteria,
even when it's obviously beneficial. Markets aren’t likely to help much,
either: Research has shown that they're not good
at reflecting the costs and benefits of events that might happen 10 or
more years in the future. Humans are naturally inclined toward inaction
in the face of great uncertainty.

The challenge is the same for
handling the biggest looming problems of global growth such as climate
change and water supply. Instead of turning inward and closing off,
humans need to cooperate and coordinate on an unprecedented scale. In
essence, we're in a race to learn fast enough to avert our own demise.
If we want to win, we'll have to change strategy soon.

Place a lit cigarette in an ashtray in a closed room where the air is perfectly still. As everyone knows, the smoke will rise, but not in a simple regular flow; the rising flow is unstable, begins to wobble, and then breaks out into a tangled mess -- turbulence. You don't need any outside cause or shock to the rising smoke to make it happen.

Economies do highly irregular things too, as a rule, going through repeated booms and busts, and yet economists seem quite hesitant to see such fluctuations as the result of similar natural instability. In recent decades, at least, they seem to have greatly preferred the idea that fluctuations around average growth must be caused by "shocks" to the economy of some kind. Noah Smith recently gave a nice summary of the Real Business Cycle theory of Kydland and Prescott, which Prescott and colleagues are still pushing today:

Here’s how recessions work. Sometimes, scientists and engineers
invent less new stuff than normal. Fewer new inventions this year mean
fewer new inventions next year, too. Anticipating this, companies invest
less, and they also cut workers' wages. When wages go down, workers
decide to take a vacation instead of work. Voila -- a recession!

Actually, I’m kidding. I don’t think this is how recessions work at all. But the theory I just described is a real macroeconomic theory. It came out
in 1982, and its name is the Real Business Cycle model. In 2004, its
creators, Edward Prescott and Finn Kydland, won a Nobel Prize for their
work. The theory inspired a generation of researchers, and became the
dominant theory in certain places, such as the University of Minnesota.

You might be forgiven for thinking that Real Business Cycle theory, or
RBC for short, doesn’t deserve its moniker. Just as the Holy Roman
Empire was none of the above, RBC theory doesn’t seem to have much to do
with business or cycles, and for that matter doesn’t sound particularly
real. Most people think that recessions are caused by asset-price
crashes, by disturbances in the financial sector, or by Federal Reserve
tightening of the money supply.

RBC says we’re all wrong about
that. The financial sector, RBC adherents claim, isn't important. Asset
prices crash because people see a recession coming ahead of time and act
accordingly. And the Fed, according to Prescott in a recent interview,
has no more effect on the economy than a rain dance has on rain. In
fact, RBC is really sort of a giant null hypothesis -- a claim that the
phenomenon known as the business cycle is just an illusion, and that
recessions are the normal, smooth functioning of an efficient economy.

In Bloomberg, I've written about some new work that puts this RBC theory into a very new light. It suggests, in fact, that theories of this basic class, if examined more closely, actually predict the existence of inherent instabilities in economies. Specifically, if you relax even slightly some of the heroic assumptions usually employed in such theories -- regarding agents' perfect rational foresight, or the ability of firms to adjust their output instantaneously to changing economic conditions -- then these models become unstable, so that large recessions will happen even without any external shocks, simply because of coordination failures within the economy.

More people should know about this work, which is the result of a serious collaboration between some physicists AND economists. Full text of the Bloomberg piece below:

****
Economists still don't know what makes it happen. An economy thrives
for years, and then suddenly, without warning, falls into a hole.
Unemployment soars until somehow, sooner or later, growth resumes. Every
economy on the planet has experienced these painful, mysterious and
apparently unavoidable slumps.

Among academics, the most popular
theory is the Big Shock, which has many variations. In this view, you
get a recession when some big thing like an oil crisis whacks the
economy, causing a corresponding reaction. Conservative economists
assume individuals and businesses will react in the best and most
rational possible way, creating an optimal economic response, so the
government shouldn't get involved. Others take the less extreme view
that governments and central banks, acting wisely, can intervene to help
an economy recover.

A few economists instead prefer what you might call the amplification theory.
They suggest that interactions between different parts of an economy
might make it possible for even tiny shocks to have big consequences,
much as a spark in a parched forest can trigger a vast fire. A small
downturn for an auto manufacturer might hurt its suppliers, undermining
their ability to supply other auto makers and creating a growing cascade
of distress. The cause is less the shock and more the links that
amplify it.

For most economists, that's the end of the discussion:
Recessions are either the result of big shocks, or of small shocks with
amplification. They ignore a third possibility: that an economy might
sometimes get seriously out of shape with no shock at all. The omission
is odd, because this way of thinking was quite common in economics some
50 years ago.

Fortunately, a group of economists and physicists
is reviving the old “no shocks” idea. Interestingly, they start with a
mathematical model of the economy built by Big Shock theorists --
specifically, the so-called Real Business Cycle model,
which still garners lots of attention from economists. Like many
mainstream economic models, it assumes that individuals and businesses
make perfectly rational, optimal decisions, which lead the economy to a
stable economic equilibrium. The new research
then makes some adjustments to this picture: It assumes that
individuals, rather than having perfect foresight when predicting future
prices, sometimes make small errors. The result is radically different.
The interactions of firms and individuals now create an ongoing
turbulence with sporadic recessions arising from a natural lack of
coordination, without any shocks at all.

The researchers go on to
show that if you make the model more realistic along any of a number of
dimensions -- firms taking a little time to adjust their production to
new levels, for example, rather than doing so instantaneously -- you
always end up with an inherently unstable economy. The conclusion is
pretty much the opposite of what the Real Business Cycle theory's
creators originally intended. They wanted to defend the notion that
markets work perfectly, not to entertain the possibility that recessions
might reflect an inability of markets to coordinate supply and demand.
Their own model actually destroys that hope.

It's an amusing and
ironic outcome, with implications beyond recessions. For years, many
economists have argued that their assumptions of perfect rationality,
self-interest and equilibrium are merely convenient elements in valuable
thought experiments; they learn about the real world despite the
manifestly false assumptions. That position now looks completely
indefensible. It looks more as if Big Shock theorists are worried that
relaxing their assumptions will lead to some very different and very
inconvenient conclusions.

This isn't to say that we know for sure what really causes big
recessions. Big shocks, little shocks and inherent instability may all
play a role. It will take some honest science to figure that out.

I've been quite lazy recently and haven't managed any posts. I haven't even managed to post several things I've written for Bloomberg. Jeez. So, catch up time.

First, I encourage everyone to watch this great TED talk by British comedian Tony Hawkes. It's inspiring. He makes a crazy proposal for a maximum income scheme; it's crazy but also really different and creative. He doesn't want to limit rich people or tear them down, but to help them do even better, and to help everyone else in the process. It's an idea of how we could set up institutions so that people work hard to be nice and to do socially beneficial things.

I wrote about this for Bloomberg here, but full text follows also below. I'm sure this isn't exactly the RIGHT idea, but there's a nub of something really cool here. It would be great if ideas like this were actually discussed in real policy circles:

******
Concern about rising wealth and income inequality has generated all
kinds of solutions, often focused on improving the lot of the people at
the bottom with measures such as minimum wages. But instead of putting a
floor on what people get, why not put a ceiling on how much they get to
keep?

The idea of a cap on income sounds crazy, and most economists find it unthinkable -- as evidenced
by the cries of incredulity Oxford professor Simon Wren-Lewis recently
elicited when he brought up the idea in an academic discussion. The
obvious response is that anything of the kind would automatically kill
economic creativity by destroying the wealth incentive that drives
entrepreneurs to start new businesses.

But is this really true?
Or does this way of thinking merely lack imagination? Maybe there's a
clever way to design an income cap that wouldn't deter business at all.

One idea comes, unexpectedly, from Tony Hawks, a British comedian and writer. Hawks is best known for his best-seller
"Round Ireland With a Fridge," a recounting of his effort to win a
100-pound drunken bet by hitchhiking around the circumference of Ireland
with a medium-sized refrigerator (he did it). He later wrote another
book, "Playing the Moldovans at Tennis," about his quest to track down,
play and beat each of the members of the Moldovan soccer team one-on-one
at tennis (he did that, too).

The poverty Hawks encountered in
Moldova, though, made him rethink the value of the wealth and fame he
had achieved. He decided to donate 50 percent of the royalties from his
second book to a trust fund for beneficial projects in the country. A
few years later, after the money had paid for a new care center in
Chisinau for children with cerebral palsy, Hawks had an epiphany.

“I met the children and their parents, saw their smiles,” he recalls,
“and the experience really enriched my life. I now actually feel good
about myself. Undoubtedly, I feel happier since I did this.”
Hawks's realization that doing good could prove far more valuable to him
than the foregone 50 percent of his royalties led to an idea: an income cap that would apply to money but not to wealth in the broadest sense.

Suppose that people, after paying ordinary income taxes, would be
allowed to keep up to, say, $500,000 of their income, then would be
obliged to give away the rest to the charities of their choice -- or, if
they like, to a charity of their own design and creation. Such a policy
would encourage a rapid proliferation of philanthropic organizations
competing to attract the money -- much like the amassing of financial
wealth has fueled the money-management industry. More people would be
able to find jobs doing good things, and society would benefit from
their efforts and resources.

The wealthy, too, would benefit. Many studies have shown
that the more money one has, the less happiness one derives from each
added dollar of income. This may explain why many of the super-wealthy,
such as Warren Buffett and Bill Gates, ultimately turn to philanthropy
-- making yet more money matters little to them in comparison with what
they can get back by helping others.

With Hawks's income cap
policy, the wealthy would end up competing not just to earn the most
money, but also to outdo others in making wise and useful gifts to the
best charities, or to start and manage charities reflecting their
values. A virtuous circle would be created. The philanthropic activity
generated by such a policy might significantly reduce the need for many
taxpayer-funded government programs, reducing the need for income taxes.

The idea actually resonates quite well with the spirit of
capitalism. Huge taxes on the rich don't work: They naturally breed
resentment and stifle creativity. Governments are often very bad at
redistributing the money efficiently. Besides, people shouldn't be
punished for working hard and being successful. They should be rewarded
and encouraged.

People care about more than money, and our
policies should harness this fact in a smart way. Hawks has at least the
nub of a very good idea. It might not be the ultimate answer, but it
has the seeds of something very clever in it. We need to work harder at
imagining what might be possible with policies that encourage the better
parts of human nature, rather than merely channel people toward gaining
as much wealth as possible.

Monday, August 11, 2014

Imagine you had never read any textbook economics, or studied any academic research papers. You didn't know the THEORIES of economics, especially in their mathematical form. But suppose you did know some mathematics, and were also generally well informed about the realities and complexities of real world economies. Now, suppose a demon sat you down and made you read and study the famous theorems concerning the existence of a competitive economic equilibrium as developed in the 1950s by Ken Arrow and Gerard Debreu. What would you think?

My belief is that you would quickly conclude that these theorems probably held little or no importance for understanding any real world economic system. If the demon tried to tell you that these theorems were at the very core of today's theoretical approach to (much of) economics, you'd think he or she was joking. If the demon insisted, you'd suspect you were dealing with an insane demon; and if you discovered the demon was right, you suspect the economics profession of being deranged. At least I would...

I've never yet been able to understand why the economics profession was/is so impressed by the Arrow-Debreu results. They establish that in an extremely abstract model of an economy, there exists a unique equilibrium with certain properties. The assumptions required to obtain the result make this economy utterly unlike anything in the real world. In effect, it tells us nothing at all. So why pay any attention to it? The attention, I suspect, must come from some prior fascination with the idea of competitive equilibrium, and a desire to see the world through that lens, a desire that is more powerful than the desire to understand the real world itself. This fascination really does hold a kind of deranging power over economic theorists, so powerful that they lose the ability to think in even minimally logical terms; they fail to distinguish necessary from sufficient conditions, and manage to overlook the issue of the stability of equilibria.

I just came across this old post from Yves Smith which makes the point rather nicely:

The scientific pretenses of economics got a considerable
boost in 1953, with the publication of what is arguably the most
influential work in the economics literature, a paper by Kenneth Arrow
and Gérard Debreu (both later Nobel Prize winners), the so-called
Arrow-Debreu theorem. Many see this proof as confirmation of Adam
Smith’s invisible hand. It demonstrates what Walras sought through his
successive auction process of tâtonnement, that there is a set of prices
at which all goods can be bought and sold at a particular point in
time.42 Recall that the shorthand for this outcome is that “markets
clear,” or that there is a “market clearing price,” leaving no buyers
with unfilled orders or vendors with unsold goods.

However, the conditions of the Arrow-Debreu theorem are highly
restrictive. For instance, Arrow and Debreu assume perfectly competitive
markets (allbuyers and sellers have perfect information, no buyer or
seller is big enough to influence prices), and separate markets for
different locations (butter in Chicago is a different market than butter
in Sydney). So far, this isn’t all that unusual a set of requirements
in econ-land.

But then we get to the doozies. The authors further assume forward
markets (meaning you can not only buy butter now, but contract to buy or
sell butter in Singapore for two and a half years from now) for every
commodity and every contingent market for every time period in all
places, meaning till the end of time! In other words, you could hedge
anything, such as the odds you will be ten minutes late to your 4:00
P.M.meeting three weeks from Tuesday. And everyone has perfect
foreknowledge of all future periods. In other words, you know everything
your unborn descendants six generations from now will be up to.

In other words, the model bears perilous little resemblance to any
world of commerce we will ever see. What follows from Arrow-Debreu is
absolutely nothing: Arrow-Debreu leaves you just as in the dark about
whether markets clear in real life as you were before reading
Arrow-Debreu.

And remember, this paper is celebrated as one of the crowning achievements of economics.

Tuesday, July 29, 2014

I've written before about the insidious stupidity of relying on simple minded economic cost-benefit calculations when thinking about complex issues such as climate change, trade policy and the like. The calculation gives the illusion of hard-headed quantitative analysis, unbiased by emotion, yet such calculations almost always make sweeping assumptions about what things get counted as costs or benefits and what things do not. There is often nothing scientific in the exercise at all.

I'm not alone in finding this troubling.

Economists in practice spend a lot of time
thinking about market failures and how to prevent them, and they derive much
of their policy advice from this recipe. Such analyses
inevitably tap into the analytical machinery for welfare analysis
(which, I admit, I find hard to take at all seriously, but that's another
story) and consider how some policy intervention, by removing obstacles
to possible exchanges in the market, can improve welfare and economic
efficiency. The trouble is, as economists Daron Acemoglu and James Robinson pointed out a while ago, is that the conceptual
framework used in such analyses often simply dismisses as irrelevant
other non-economic impacts of such policies, even though these may have
huge societal ramifications. Here's how they described one example (I'm selecting some text here from an earlier post):

Faced with a trade union exercising monopoly power and raising the wages
of its members, many economists would advocate removing or limiting the
union’s ability to exercise this monopoly power, and this is certainly
the right policy in some circumstances. But unions do not just influence
the way the labor market functions; they also have important
implications for the political system. Historically, unions have played a
key role in the creation of democracy in many parts of the world,
particularly in western Europe; they have founded, funded, and supported
political parties, such as the Labour Party in Britain or the Social
Democratic parties of Scandinavia, which have had large effects on
public policy and on the extent of taxation and income red istribution,
often balancing the political power of established business interests
and political elites. Because the higher wages that unions generate for
their members are one of the main reasons why people join unions,
reducing their market power is likely to foster de-unionization. But
this may, by further strengthening groups and interests that were
already dominant in society, also change the political equilibrium in a
direction involving greater effifi ciency losses. This case illustrates a
more general conclusion, which is the heart of our argument: even when
it is possible, removing a market failure need not improve the
allocation of resources because of its effect on future political
equilibria. To understand whether it is likely to do so, one must look
at the political consequences of a policy—it is not sufficient to just
focus on the economic costs and benefits.

The paper goes on to analyze this problem in much greater generality,
looking at the push to privatization in Russia, and the drive to
deregulate financial markets over the past three decades in Western
nations, and how both led to huge shifts in the wealth and political
power of different social groups. In both cases, much of the
intellectual groundwork for making these changes came from analyses that
were ridiculously oversimplified and carried out with considerable
disregard for the larger complexity of society.

On the same topic, here's a must read article at Salon.com by Ted Hamilton, a Harvard Law student, decrying the stultifying effects of the "law and economics" movement on the teaching of law. One of the most pervasive effects is the rise of the concept of economic "efficiency" in analyzing and judging the relative merits of different legal structures. The result, as Hamilton describes it, is the systematic narrowing of thinking and stamping out of any imaginative or creative analysis in law:

Since September, I’ve been encouraged to think about the law less as a
journey toward justice and more as a means for distributing resources.
In Civil Procedure, we examined the wisdom of allowing average people to
bring lawsuits based on the overall court costs involved. And in
Property, the problem of whether to permit the building of a cement
plant in a residential neighborhood turned on the national industry’s
need for cement. In nearly every discussion of a given law or a proposed
policy, the first question was feasibility, and the second (or third)
was justice. “Feasibility” means financial soundness. Financial
soundness requires measurement. So in order to measure and mete out our
resources, legal questions grasp for the harsh insights of computation.

According
to this oddly constrained worldview, the legal system is just another
(and comparatively imperfect) means for achieving “wealth maximization.”
We want a “bigger pie,” so the incessantly repeated metaphor goes, and
law is merely about deciding which yeast works best. The impassioned cris de coeurs of Blackstone, Cardozo or Sotomayor notwithstanding, “the life of the law” is not, to paraphrase another luminary,
“experience” — it’s accounting. If only we would spend less time with
the romantic and messy concepts that have beguiled the likes of Holmes
and Brandeis for millennia, so the thinking goes, we might actually be
able to make things work.

In the obvious — and
obviously ideological — corollary to all this, law school has tried to
convince me that it’s not lawyers or judges that should decide the hard
questions of law: It’s economists. The white knights of the 21st century
legal academy, economists are uniquely equipped, so they claim, to
furnish us wishy-washy idealists with the quantitative rigor to perform
the difficult, and consummately serious, analysis that policy and
politics require.

In other words, society is a problem. And legal economics is here to solve it.

The
law and economics movement, born at the University of Chicago in the
1970s, gave birth to this type of thinking and now enjoys unquestioned
academic supremacy over the more prevaricating methods of legal realism,
critical legal studies and legal formalism. Law and economics’ doyen
Richard Posner, a professor at Chicago, Seventh Circuit judge and famous
advocate of all things market-oriented, is the most cited legal
academic of the 20th century. Ronald Coase’s “The Problem of Social
Cost,” which reduces debate over legal rules to the calculation of
transaction costs, is the most cited legal article. Passions have cooled
somewhat since the raucous debate in the ’80s and ’90s over law and
economics’ takeover of the legal academy — which was aided in no small
part by generous donations from private, free market-promoting
foundations — but that’s just because the movement’s methods have become
part of the background. No other approach to adjudication dominates
class discussion to such an extent, or shapes the way in which cases are
selected and read.

The economic analysis of law, then, has become
the standard against which other approaches are measured. And even if
many professors still believe that cost-benefit analysis, with its
incessant focus on data and calculation, brandishes empiricism the way
Descartes brandished self-reflection (read: with excessive faith in a
promising but limited approach), only a cantankerous cynic would argue
that it’s all hogwash.

But that’s not to say there isn’t much to pause over.

Here’s
a typical example: Legal economists generally assess the value of a
resource — land, loans, even lives — by how much someone is willing to
pay for it. This makes sense at a very basic level: The sandwich is
worth $8 because you won’t pay $9 but you’ll pay more than $7. But how
effectively can dollars capture worth when people have different abilities
to pay? It seems a bit obtuse to claim that the owner “willing” to pay
$200,000 for her home values it less than the developer “willing” —
read: able — to spend $1 million. And that’s just marketable
assets. What about more elusive “resources”? How do we price, say, the
happiness of children? (Don’t worry: economists have tried.)

Here’s
another example: Economic analysis evaluates environmental regulations
according to the net social value of restricting industrial activity
versus the activity’s economic value absent regulation. Even beyond the
difficulties of measuring such things, how do we decide where to draw
the line between what “counts” as value in such a calculation and what
doesn’t? When dealing with something as resistant to quantification as a
wild stream, this puzzle has no end. Is the stream only valuable to
those who live by it? To those who live in it? What about those who hear
stories about it, or who would drink from it in 90 years, or the
painters who might never see it? Does their value “count”?

... we need to consider economic thinking’s ideological and imaginative effects. ... Simply
put, our social life is much more than a pie-eating contest. Our shared
resources are meant to serve our shared ideals, not vice versa. Yes: a
rising tide might sometimes lift all ships, and we need to enjoy our
bread before we can enjoy our rights. But the two biggest specters on
our communal horizon, climate change and inequality, demonstrate where a
singleminded obsession with economic growth can lead us. Taking care of
ourselves and our planet means much more than taking care of our
wallets.

In an era crying out for radical thinking and radical
solutions, we can ill afford the strictures of the cost-benefit mindset.
The complete immersion of our legal class into this language of
economics has a corrosive effect on its imaginations, leaving our
lawyers unequipped to think outside the box. A singleminded pursuit of
efficiency loses sight of the inherent messiness of society and the
legal rules that grapple with it. By reducing everything to entries in a
formula and by seeing human behavior as limited to “rational pursuit of
maximum value,” law and economics conjures up a version of the
self-interested and self-destructive world that we now inhabit.

After
all, when we concede that our society’s legal life is essentially about
growing the economy, it becomes very hard to argue against leaving the
tough decisions of rule design and market legislation to the growth
experts and wealth maximizers. Not surprisingly, those folks have lately
turned out to be expert mostly at maximizing their own wealth and that
of their friends, while minimizing the wealth, and the happiness, of
everybody else — those less willing, because less able, to pay for their share of our resources.

Three
years of law school spent evaluating society according to the metric of
transaction costs will inevitably produce lawyers less attuned to the
more ephemeral, and more essential, considerations — the kind that could
actually inspire the reforms and revolutions we need. A law school
acculturation process whereby the hard facts of economic analysis are
constantly if implicitly vaunted over the less determinate methods of
ethical reasoning necessarily generates attorneys more sympathetic to
those who traffic in the material of such analysis — namely, bankers,
hedge fund managers, and their similarly-educated regulators — and it’s
just such economic essentialists who are overrepresented in the ranks of
the enemies of social change.

Thomas Palley has written an interesting and provocative working paper on "Gattopardo economics" -- his phrase for recent efforts to paper over the fundamental failings of mainstream economic theory by making superficial changes, thereby leaving the main structures intact. Such efforts seek "change that keeps things the same... Gattopardo economics makes change more difficult because it deceives people into thinking change has taken place. By masquerading as change, it crowds-out space for real change."

The name comes from the novel Il Gattopardo (The Leopard) by Giuseppe Tomasi di Lampedusa, about class conflict in Sicily in the 1860s. In the novel, the aristocracy engineers change of a sort that deflects the real threat to their power and leaves them still in charge.

I don't know if Palley's account of the causes of the financial crisis
and subsequent stagnation is definitely correct, but it rings true to
me. It was the end result of broad financial de-regulation, coupled with
relentless downward pressure on ordinary wages over the past few
decades driven by globalization. This set the stage for a three decade
credit bubble which ultimately burst. The part I'm not sure about is his
claim that stagnant growth now is due to a lack of aggregate demand
linked to soaring wealth inequality. Sounds plausible. Anyway, here's
his closing summary. The whole paper is worth a read:

The structural Keynesian account of the economic crisis makes clear the role of mainstream economists and the neoliberal paradigm in creating the crisis. Scratch any side of the neoliberal policy box and you quickly find the ideas of mainstream economists. Corporate globalization was justified by appeal to economists’ comparativeadvantage theory of free trade. The labor market flexibility agenda was justified by economists’ claims that unions and the minimum wage cause unemployment. The retreat from full employment was justified by the Friedman’s theory of the natural rate of unemployment which implied central banks should focus on low inflation as they cannot permanently affect unemployment. The attack on government and regulation was supported by Chicago School claims that costs of market failure are small relative the costs of government failure and policy induced market distortions. Government was also charged with diminishing freedom and paving “the road to serfdom”, so that freedom was best served by a minimalist government or night watchman state. Financial deregulation was justified by claims it would produce a free lunch by increasing efficiency of resource allocation.

After the financial crisis of 2008 many Keynesian economists hoped there would be profound change of theory within the economics profession. The profession stood discredited owing to its complete failure to anticipate the crisis, whereas Keynesian economists had anticipated the crisis and also showed how neoliberal economics contributed to it. However, change has been minimal.

That should not surprise anyone. Neoliberal economics supports the economic and political interests of powerful elites, and those elites have reason to defend it and block change. Even if only sub-consciously, professional economists also have a private (utility maximizing) interest in maintaining neoliberal ideas to the extent that they are intellectually invested in those ideas and their careers have been built on them.

Society is now engaged in a war of ideas, the outcome of which will greatly influence the future. That is because how we explain the crisis will influence the direction of future economic policy. Gattopardo economics is one of the mechanisms for blocking intellectual change. It works by muddying the water and appearing to offer change when in fact it keeps everything the same. That is why it is so important to expose gattopardo economics.

Tuesday, July 22, 2014

The thing you see above is a plant called Amaranth (this is Palmer Amaranth, one of many species). It's a superweed -- resistant to the ubiquitous and powerful herbicide Round Up -- and in many parts of the US an immense pain to farmers growing corn, soybean or cotton. They're spending millions to keep it from spreading in their fields, and not being too successful.

Now for the irony -- this plant is also completely edible and highly nutritious. It's been eaten for thousands of years around the world. Now farmers are trying to eradicate it in many cases so they can keep producing the cheap high-fructose corn syrup on which the soda and fast food and processed food industry depends. The very fuel of widespread obesity.

Friday, July 11, 2014

Very interesting paper published yesterday in Nature. It's an experimental paper, reporting the results of a cooperation game in which people try (of course!) to cooperate, but also have incentives to cheat and take more for themselves. If each pursues his or her own ends without regard for others, there's a tragedy of the commons in which a common pool resource gets wiped out. It takes cooperation and control over selfish actions to avoid disaster for everyone. Lots of experiments have looked at such matters before, of course. This one adds a twist.

The twist is to make the experiment more relevant to some of the tricky issues we face today in thinking about climate change, how to preserve the environment, etc. Someone who is today 60 years old doesn't have the same personal stake in avoiding climate change as someone who is 10, because the older one is much more likely to be dead by the time serious effects kick in. The twist in the experiment is to include this cooperation between generations effect. In effect, the experiment probes our abilities to cooperate with the future -- with people we will never meet. Clever idea to try to do this in an experiment, and I think they've managed it quite well.

Oliver Hauser and colleagues placed volunteers into groups of five people, which they called "generations." In a typical run of the game, they would give the first generation a common pool of 100 units of wealth, with each of the five individuals in this generation able to "extract" between 0 and 20 wealth units from this pool. Their choice entirely as individuals. The people know that the wealth pool will be passed on to future generations ONLY if the current generation extracts no more than half of it (50 units). Hence, individuals caring about the future generation could choose to extract, say, 10 or fewer units, while those not caring could just take 20.

The individuals were told that there actually would be a future generation with some probability p -- say, 0.8. Hence, there's a 20% chance that the game will just end, so no need to worry about future the generation, and 80% it won't, in which case the wealth resource will or will not be passed on depending how people act in this generation. This game repeats for a number of generations as determined by the random process (on average 5 for p = 0.8).

So, what happens? The research was designed to look at two different scenarios. First, where people just act as they want to without any further pressures on their behavior, and second, in the presence of various kinds of mechanisms designed to help them cooperate more effectively, preserving the resource through generations. The results are interesting:

1. Anything goes -- no institutions at all

In this case, everything goes to the dogs immediately. Interestingly, many people aren't wholly greedy and readily reduce the amount they extract so as to preserve the resource for the next generation of total strangers. The study found that over 20 separate trials, about 68% of the individuals extracted no more than 10 units. Even so, this wasn't enough the overcome the anti-social actions of a greedy minority which extracted so many units that the common pool vanished fairly quickly. In this set of experiments, there were second generations in 18 games, and only in 4 of them was the pool passed on intact through one generation. In the other 14 it was immediately wiped out by over-extraction.

Lesson: people aren't all bad, most have pretty good intentions, but the persistent efforts of a small minority of greedy cheaters is enough to mess everything up. In no single case did the common resource pool persist past 4 generations.

2. Anything doesn't go -- behaviour control by democracy

Maybe democracy can help? An alternative might be to have people in any generation hold a vote on how much of the resource should be passed on. Then, the result (taken as the median or more common choice among the voters) would determine the actual behavior of each and every individual. Freedom would reside in having a vote, not in just being able to extract what you like.

As the paper notes, there are some results in game theory that -- in the context of rational, self interested agents playing normal public goods games -- show that this kind of trick gives very good results. When selfish individuals can be strategic about getting something back from their cooperation, they can do so. However, this standard result does not apply in this generational game because no individual can gain anything by being cooperative. The first generation of rational greedy people would simply vote to each take 20 units and the resource would be gone. Who cares about those people in the future, anyway.

But of course, that's only if people really are rational and greedy. What about real people? Here the experiments suggest something encouraging. In another 20 trials, the researchers tested this protocol and found that now the resource pools never vanished even once, but were passed on and replenished by the unselfish voting of people for as long as the games persisted. The non-greedy norms of the majority, when linked to the coordinating mechanism of democratic voting, can overcome the greed of the uncaring minority -- in this very simple setting.

The message that the simple institution of democratic voting -- IF the outcome of the vote is then effectively enforced on the behavior of all individuals -- can be hugely beneficial for overcoming intergenerational tragedies of the commons. Secondarily, that analyses of what is possible in overcoming these kinds of problems is misleading and naive if conducted in the framework of strictly self-interested agents; pro-social norms in the behavior of real people are a resource for cooperation that we can put to good use. As the paper concludes:

We have shown that in the absence of regulation, a minority of selfish players consistently deplete available resources. By implementing median voting, however, this negative outcome can be prevented—but only if all players are bound by the outcome of the vote. Votes that are only partially binding, such as the international Kyoto protocol, have little power.

More generally, our results emphasize the importance of institutional designers moving away from the assumption of universal self-interest. We extend the ‘behavioural public choice theorem’ by demonstrating how voting can allow amajority of pro-social individuals to override a purely selfish minority, leading to costly group-level cooperation with future generations. Real-world data are consistent with this suggestion: countries that are more democratic also have more sustainable energy policies... Policymakers can do much to promote the public good by using a behavioural approach that is informed by amore accurate understanding of human psychology. Many citizens are ready to sacrifice for the greater good. We just need institutions that help them do so.

This final comment reminds me of a European economist who I met several years ago at a European Commission meeting. Very polished, frightfully clever, Oxford and Cambridge, LSE and all that. In conversation, he made fun of all those silly people who recycle and try to take small steps to conserve energy, and had a really good laugh (all on his own) about their little minds and cute intentions to push our world in a better direction. All very silly, he said, because it will never amount to much. Nothing would really matter until it was determined what to do by people such as himself and then put into practice at an international level.

What seemed not to register in his brain at all was what all that small-sacrificing behavior actually reflects -- a desire to help, to make a difference, to change things, to care. Many people aren't only self-interested, and all their tiny efforts show it. They want to help solve the big problems. So that final sentence in the paper is exactly right: "We just need institutions that help them do so."

Saturday, June 28, 2014

Books on economic policy aren't generally page turners. But a new book by economist David Colander and businessman Roland Kupers certainly is. It makes the argument that some of the assumptions economists made many decades ago -- especially about people having fixed preferences -- have effectively created a trap for policy analyses. We're stuck as a result with endless, useless arguments about markets versus government. Change those assumptions, and it's possible to imagine policies that don't have markets and government in opposition; it ought to be possible to have free markets and a useful and smaller government at the same time, and achieve not only material prosperity but a wide range of social goals too.

I wrote about the book in a Bloomberg column a few days ago. That column has garnered all of 4 comments so far, which I think also illustrates another problem we have. The column is all about how we might find a way around all of the sterile arguments of markets vs government, and not too many people seem to be interested in that.... or at least not motivated to comment. From past experience, I know that any column which seems to take a side in those arguments stirs up a lot of protest.

Anyway, read Colander and Kupers' book. Here's the column:

From financial regulation to health care to climate change, we can't
agree on what to do about anything. Free-market enthusiasts celebrate
the creative power of markets and want smaller government; critics
counter that we desperately need government intervention to solve
problems that markets can't handle. Neither side can understand the
other.

Is there any way out? Well, if you're discouraged, I
suggest looking to an inspiring new book by an economist, David
Colander, and a businessman, Roland Kupers, who believe the deadlock
needn't be permanent. We can have better markets, they say, and more
effective (and smaller) government too, if only we can muster a little
more economic imagination.

The book is called ``Complexity and the Art of Public Policy,'' and
its main point is that our policy debates have fallen into a trap that
economists inadvertently created some 50 years ago. That's when they
started building mathematical models of economic systems, and, to
simplify things, made the assumption that people have fixed or
unchanging preferences and desires. Sounds innocuous; it wasn't, and
isn't. Read more.

Friday, June 6, 2014

In comments on my last post, Gekko asks quite rightly why I've been doing this silly business of posting two paragraphs and then linking to "more at Medium." It's a good question, so let me explain what's going on. I know it's irritating, and I'd like not to do it, but ....

A while back, Medium asked me to write some things for them. They pay a few writers (a little, very little, in my case) and are in the stages of trying to get their project growing. What it will grow into remains unknown. I do like their layout, and would like to be involved in Medium if and when it turns into the next big thing, whatever that might be.... but I also don't want to just go over there and abandon my blog. First, Medium is just articles; you can't have any sidebars with links to other people's sites, and I think such links are valuable, so visiting there is very different. Two, I don't know if Medium won't just disappear two months from now.

So, I'm left with this very unsatisfying business of posting two paragraphs here, and then linking there. (By contract, I'm not supposed to post in both places, at least not before a significant delay.). I'm not sure what else to do. The dilemma has in fact hurt my blogging, as some days I've started writing about something, then fallen into internal debate about whether to post here, or over there, or what else I might do, and then.... just gave up after an hour and did something else, like clean the gutters or walk the dogs.

Wednesday, June 4, 2014

I am on occasion a fairly harsh critic of modern economics, for many reasons. I think economists use the concept of efficiency in a slapdash manner. I think they make a fetish of rigorous mathematics even when they gain no insight from it; it's too often imported as a tool to impress others, rather than as a legitimate means to understanding (see the absurd Appendices of this paper, for example, proving various irrelevant theorems about Markov processes). I think economists (most of them) don't make use of enough modern mathematics from dynamical systems theory.

I also think economists often infect their social analysis with their own subjective values, even while mistakenly and dangerously believing otherwise (as a result of their training). I think the modelling assumption of rational expectations, for agents dealing with anything but the simplest environments, is just a silly idea. I would go so far as to say that I think many economists don't appreciate basic elements of scientific method, preferring the logical beauty (?) of deductive theories to empirically relevant ones. Etc. Read almost anything I've written on this blog for similarly critical opinions.

But I do, just the same, also think there's lots of good and useful economics, some of it even beautiful. And I think economists themselves should do a better job standing up for it. Some very prominent and well known economists are giving the field a bad name. Let me explain.

Friday, May 23, 2014

Professors of economics at the
University of Chicago like being provocative. Following the tradition of
Milton Friedman, they enjoy causing a stir by making crazy, freaky
claims in public. So it is really no surprise to hear economist Steven
Levitt of Freakonomics fame make the claim that “it doesn’t
take a whole lot of smarts or a whole lot of blind faith in markets to
recognize that when you don’t charge people for things (including health
care), they will consume too much of it.” This is why, he suggests, a
country such as the UK would benefit by replacing their silly publicly
funded healthcare system with a truly free market where people would
have to pay for everything — the market could then through the price
mechanism work its miracles and produce a vastly superior outcome,
without anyone being tempted to over-consume.

I
suspect that Levitt cannot possibly believe this — at least I hope not.
If he does, then he has an embarrassingly woeful knowledge of the
literature in his own field, as it doesn’t take a lot of smarts to
realize that this statement ought to come with about 10 pages of
qualifications and conditions. For a dose of reasoned good sense on the
topic, see commentary by Noah Smith, and also this excellent insight from Cameron Murray. Makes you wonder by how many decades the Freakonomics series has actually set back the public understanding of economics.

But
in the spirit of “Thinking like a Freak” — a new book pushing bold
thoughts of this kind by Levitt and co-author Stephen Dubner — I thought
I’d try to see if Levitt’s idea, taken seriously, might lead to
something interesting. I think it does. Perhaps Levitt really is on to
something freaky big and astonishingly brilliant, if we’re only brave
enough to follow the logic through to its end without fear or trembling.
Let’s suppose Levitt is right that “when you don’t charge people for
things… they will consume too much of it,” and let’s think about the
causes of climate change, as well as possible remedies. Read more at Medium.

Tuesday, May 6, 2014

I have a new column out in Bloomberg looking at some arguments by conservative economists against Thomas Piketty's work on inequality. I stumbled last week across this post by Tyler Cowen, which Barkley Rosser helpfully put into context. Cowen claimed that we don't really need Piketty
because several earlier studies "already give an explanation" for the observed wealth inequality. Really? It turns out, he suggested, that you don't need any stories about returns to investment growing faster than wages. Standard economic models have already shown that inequality may just be the
consequence of simple things like differences in personal patience
(rich having more, of course, and the poor less), or in the effects of random
shocks to peoples' ability to earn over their lifetimes.

Really?

Having looked into it, I now think this is a perfect example of Chameleon Economics, as recently described so brilliantly by Paul Pfleiderer. You tuck some preposterous assumptions A into a model, derive some apparently interesting result X, and then hope that people will soon forget about A so you can go around saying "we've shown that X" holds. The preposterous assumptions A might even include an assumption that is essentially equivalent to X, so you've assumed the result you want to prove. This trick is the real basis of the papers that Cowen pointed to, but jeez -- the authors did such a good job of plastering their arguments over with 50 odd pages of technical mumbo jumbo that it took quite a lot of effort to see what they were up to. In the paper by Krusell and Smith, for example, you can read on and on in utter semi-conscious misery before you begin to find the real secret of what the authors have done, as they finally admit:

When the representative-agent model is altered only by adding idiosyncratic, uninsurable risk, the resulting stationary wealth distribution is quite unrealistic: there are too few very poor agents, and much too little concentration of wealth among the very richest. For this reason, we consider a version of the model with preference heterogeneity: agents have random discount factors, whose values have a symmetric distribution with a small variance and whose transition probabilities are such that the average duration, or life length, of a discount factor equals that of a generation. In this fashion, we incorporate genetic differences in the population that are passed on imperfectly from parents to children. We show that this model does succeed quite well in matching the key features of the wealth distribution.

In other words, they start out seeking an explanation for the unequal distribution of wealth -- why do some people have so much more than others? Ultimately, they find that this result tumbles directly out of their economic model, IF they make the assumption that some people in the model are more patient than others, and are therefore better at saving and accumulating wealth than others. There you go -- the whole result from that one assumption (plus some others)! Science advances!

I'm reminded of the famous claim of the doctor in Moliere, explaining how opium induces sleep? "By virtue of a faculty," the virtus dormitiva, he said, "the nature of which is to put the senses to sleep." Fortunately, Moliere was writing comedy, not pretending to do science.

Anyway, how about the following for a funny coincidence. Courtesy of a kind invitation from Ole Peters, I'm spending May at the London Mathematical Laboratory, a small mathematics center in Central London. Last week we were discussing Piketty's book, which Alex Adamou, one of the researchers here, has been diligently working his way through. Ole boldly suggested that maybe we should try to get Piketty to come here and give a talk on the book, whereupon we all chuckled at the very idea, thinking it preposterous given the outrageous current demands on his time. Piketty seems to be on a worldwide tour of epic proportions.

Yet this afternoon we learned that, at the very moment of our discussion, Piketty was actually in the very same building, one floor above our heads, giving a talk to a public policy think tank! Had we been speaking a bit louder, he might have heard us!

Tuesday, April 22, 2014

What's the future of macroeconomics? Does it lie in further development of the old-style models of rational optimizers and equilibrium, the dynamic stochastic general equilbrium (DSGE) models? Or will it instead be a new breed of agent-based computational economics (ABM), i.e. in computational simulations which don't restrict themselves to rational optimizing behavior, or to equilibrium?

From what I see, the DSGE people -- the old guard, if you will, as this IS the current mainstream approach -- don't take the opponent very seriously. They seem to sneer and chuckle at ABM for its lack of mathematical rigor; they don't even prove theorems! BUT, I suspect, this is only because the DSGE people secretly know very little at all about ABM, about its potential, its power and flexibility, and especially, about how far it has been developed already, for exploring banking stability, monetary policy and so on. DSGE, as I see it, is doomed for sure. It's not going to be a fair fight.

DSGE is the Titanic of economic methodology, already taking on water, its bow looming high in the air. Message to young economists: Don’t let your career go down with it! Read more at Medium.

Friday, April 18, 2014

Several people working for the hedge fund AQR Capital Management have a working paper which looks at trend following strategies over about a century. It finds they're generally very profitable, which is surprising, I guess, if you're an EMH nut and simply can't muster the imagination required to believe that markets contain identifiable momentum. From that paper:

As an investment style, trend-following has existed for a very long time. Some 200 years ago, the classical economist David Ricardo’s imperative to “cut short your losses” and “let your profits run on”suggests an attention to trends. A century later, the legendary trader Jesse Livermore stated explicitly that the “big money was not in the individual fluctuations but in... sizing up the entire market and its trend.”

The most basic trend-following strategy is time series momentum– going long markets with recent positive returns and shorting those with recent negative returns. Time series momentum has been profitable on average since 1985 for nearly all equity index futures, fixed income futures, commodity futures, and currency forwards.

The strategy explains the strong performance of Managed Futures funds from the late 1980s, when fund returns and index data first becomes available. This paper seeks to establish whether the strong performance of trend-following is a statistical fluke of the last few decades or a more robust phenomenon that exists over a wide range of economic conditions. Using historical data from a number of sources, we construct a time series momentum strategy all the way back to 1903 and find that the strategy has been consistently profitable throughout the past 110 years.

Now comes another study doing much the same kind of analysis, but going back as far as 200 years, and finding pretty much the same thing. Yes, trend following works, and it always has. No, the markets are not efficient. I've written a little more at Medium.

Friday, April 11, 2014

By way of Unlearning Economics, who has made the effort of plowing through the details of the paper, read below and see if you've ever had a similar experience while reading some new and allegedly exciting "advance" in macroeconomic theory:

How Not to Do Macroeconomics

A frustrating recurrence for critics of ‘mainstream’ economics
is the assertion that they are criticising the economics of bygone days:
that those phenomena which they assert economists do not consider are,
in fact, at the forefront of economics research, and that the critics’
ignorance demonstrates that they are out of touch with modern economics –
and therefore not fit to criticise it at all.

Nowhere is this more apparent than with macroeconomics.
Macroeconomists are commonly accused of failing to incorporate dynamics
in the financial sector such as debt, bubbles and even banks themselves,
but while this was true pre-crisis, many contemporary macroeconomic
models do attempt to include such things. Indeed, reputed economist Thomas Sargent
charged that such criticisms “reflect either woeful ignorance or
intentional disregard for what much of modern macroeconomics is about
and what it has accomplished.” So what has it accomplished? One attempt
to model the ongoing crisis using modern macro is this recent paper
by Gauti Eggertsson & Neil Mehrotra, which tries
to understand secular stagnation within a typical ‘overlapping
generations’ framework. It’s quite a simple model, deliberately so, but
it helps to illustrate the troubles faced by
contemporary macroeconomics.

The model

The model has only 3 types of agents: young, middle-aged and old. The
young borrow from the middle, who receive an income, some of which they
save for old age. Predictably, the model employs all the standard
techniques that heterodox economists love to hate, such as utility
maximisation and perfect foresight. However, the interesting mechanics
here are not in these; instead, what concerns me is the way ‘secular
stagnation’ itself is introduced. In the model, the limit to how much
young agents are allowed to borrow is exogenously imposed, and
deleveraging/a financial crisis begins when this amount falls for
unspecified reasons. In other words, in order to analyse deleveraging,
Eggertson & Mehrotra simply assume that it happens, without asking
why. As David Beckworth noted on twitter,
this is simply assuming what you want to prove. (They go on to show
similar effects can occur due to a fall in population growth or an
increase in inequality, but again, these changes are modelled as
exogenous).

It gets worse. Recall that the idea of secular stagnation is, at
heart, a story about how over the last few decades we have not been able
to create enough demand with ‘real’ investment, and have
subsequently relied on speculative bubbles to push demand to an
acceptable level. This was certainly the angle from which Larry Summers and subsequent commentators approached the issue. It’s therefore surprising – ridiculous, in fact – that this model of secular stagnation doesn’t include banks, and has only one
financial instrument: a risk-less bond that agents use to transfer
wealth between generations. What’s more, as the authors state, “no
aggregate savings is possible (i.e. there is no capital)”.Yes, you read that right. How on earth
can our model understand why there is not enough ‘traditional’
investment (i.e. capital formation), and why we need bubbles to fill
that gap, if we can have neither investment nor bubbles?

Naturally, none of these shortcomings stop Eggertson & Mehrotra
from proceeding, and ending the paper in economists’ favourite
way…policy prescriptions! Yes, despite the fact that this model is not
only unrealistic but quite clearly unfit for purpose on its own terms,
and despite the fact that it has yielded no falsifiable predictions (?),
the authors go on give policy advice about redistribution, monetary and
fiscal policy. Considering this paper is incomprehensible to most of
the public, one is forced to wonder to whom this policy advice is
accountable. Note that I am not implying policymakers are puppets on the
strings of macroeconomists, but things like this definitely contribute
to debate – after all, secular stagnation was referenced by the Chancellor in UK parliament (though admittedly he did reject it). Furthermore, when you have economists with a platform like Paul Krugman endorsing the model, it’s hard to argue that it couldn’t have at least some degree of influence on policy-makers.

Thursday, April 10, 2014

This article by political scientist Larry Bartels makes fascinating, if depressing, reading. In brief, a forthcoming study shows that the political influence of the wealthy is an order of magnitude larger than that of the poor (with wealthy and poor, of course, defined in a particular way). Democracy isn't the fair and equitable system you might have thought it was (if you were naive enough to think it was.... as, apparently, most political scientists still are).

Wednesday, April 2, 2014

I have an essay coming out in Bloomberg tonight which looks at the fascinating article I recently mentioned by Nick Hanauer and Eric Beinhocker. I've also posted some further discussion over at Medium on one particular aspect of their article -- the notion that capitalism is best understood as an evolutionary process for finding solutions to human problems. It's messy, wasteful, chaotic, and that's precisely why it works -- by allowing a parallel exploration by many minds of the huge space of possible solutions to human problems. Capitalism is an algorithm in much the way evolution is an algorithm (or at least is LIKE an algorithm).

Friday, March 28, 2014

By way of Mark Thoma, an absolutely brilliant paper by economist Paul Pfleiderer of Stanford University looking at how economists use and abuse models. As he points our, if you make the right assumptions (ignoring market "distortions" such as liver disease, DUIs, etc.), then it's possible to show in a rigorous model that "it is optimal for humans to be drinking all of their waking hours." I've written some more over at Medium.

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Who am I?

Physicist and science writer. I was formerly an editor with the international science journal Nature and also the magazine New Scientist. I am the author of three earlier books, and have written extensively for publications including Nature, Science, the New York Times, Wired and the Harvard Business Review. I currently write monthly columns for Nature Physics and for Bloomberg Views.